Public Pension Investments: Risky Chase for High Returns

A recent Pew report shows a systematic shift of public pension plans away from fixed-income investments toward equities and alternative investments in the last 30 years.

A recent Pew report shows a systematic shift of public pension plans away from fixed-income investments toward equities and alternative investments in the last 30 years. Using investment data on public pensions from 1952 to 2012, Pew found public plans “significantly increased their reliance on stocks” during the 1980s and 1990s.

The data reveal fixed-income investments and cash constituted nearly 96 percent of public pension assets in 1952. The proportion decreased to 47 percent by 1992 and had dropped to 27 percent by 2012. During the past decade, public pension funds have allocated an increasing share of their assets to alternative investments, including private equity, hedge funds, real estate, and commodities. From 2006 to 2012, the share of pension assets in these alternatives more than doubled, from 11 percent to 23 percent.

Unrealistically high assumed rates of return are the cause behind this shift.

Aggressive Response

From 1992 to 2012, while the average annual yield on 30-year Treasury bonds declined by 4.75 percentage points, from 7.67 percent to 2.92 percent, the medium pension fund’s assumed rate of return decreased by only 0.25 percentage points, from 8 percent to 7.75 percent. That means pension funds have to be much more aggressive than in the past to earn their assumed rates of return, hence the shift to equities and alternative investments.

Although moving away from fixed-income securities allows pension funds to keep up with the high assumed rates of return, it also entails substantial risk. Higher risk means higher volatility, which implies higher chances of incurring losses.

Pension expert Andrew Biggs made the same point not long ago. Biggs estimated a portfolio in 1975 could earn an annual expected return of 8 percent with a standard deviation of 3.7 percent, losing money on average only once every 65 years. By contrast, a portfolio today must have a standard deviation of 14 percent to get the same expected return, suffering losses about once every four years.

In finance, standard deviation is a measure of how much an investment’s returns can vary from its average return, or in other words, how “spread out” these returns are. It is, therefore, a measure of volatility. The higher the standard deviation, the greater the volatility, and thus the riskier the investment.

Huge Deviations

Larger pensions and riskier investments therefore create a substantial threat to state and local budgets. In 1975, the standard deviation of public pension investments amounted to only 1.8 percent of state and local budgets, whereas it has increased tenfold to a whopping 19.8 percent today.

Higher risk is not only about higher volatility. It also involves higher responsiveness to market movements (in financial terms, it means a higher “Beta”). The implication is that riskier investments such as equities and alternative investments tend to move more in tandem with the market, and their change in values is more magnified by market change. In other words, when the market performs well, these investments can earn large returns, but when the market falls, the investments dive even deeper than the market, risking large unfunded liabilities.

Vicious Cycle

Unfortunately, state and local governments’ revenues typically plunge during market downturns, meaning pension systems’ unfunded gaps balloon when government budgets are most constrained and thus least able to make up for the shortfalls. This potentially creates a vicious cycle: pension plans that suffer substantial losses during recessions lack money to reduce funding gaps, thereby have an incentive to invest more in risky assets with a hope of earning larger returns to reduce the debts, and thus expose government budgets to even more risk.

The use of unrealistic rates of return stems from a flawed approach to liability valuation. Instead of using a near-risk-free rate to value pension liabilities, public pensions rely on the expected rates of return of pension assets, which can be easily manipulated to artificially reduce the required contributions and conceal the real funding gap.